Watch the policy rate in real terms, but worry about how little it matters

Financial Express, 7 March 2009

What happened to the short rate, expressed in real terms?

In August 2008, looking forward into the future, inflation was expected to be strong and growth was expected to be moderate. With inflation running at roughly 8%, RBI chose a short-term rate of roughly 8% which gave a real rate (at the short end) of roughly 0%. This was criticised as being an expansionary monetary policy at a time of substantial inflationary pressure.

There has been a sea change ever since: inflationary expectations have subsided and growth expectations has dropped. If reasonable values for lowered inflationary expectations and reduced growth expectations were put into any reasonable monetary policy rule, this would have yielded a rapid drop in the short-term rate to zero. This did not happen. As a consequence, monetary policy has tightened greatly -- the real rate has gone up sharply - at a time of an unprecedented downturn. This is hard to justify.

From August 2008 to January 2009, the WPI shows annualised inflation of -15%. From October 2008 till January 2009, the CPI-IW shows inflation of 0. In this period, RBI chose a short-term rate of roughly 4%. This gives a policy rate -- in real terms -- of roughly 19% going by WPI and roughly 4% going by CPI. In other words, when the downturn came, RBI sharply tightened monetary policy - raising the real rate from 0 to a value between 4% and 19% depending on what inflation measure is to be trusted. This contradicts what we expect monetary policy to do when facing a downturn.

Thus, while RBI's cutting rates by 50 bps is on the right track, there are deeper problems with economic analysis at RBI. It is true that ex-post, it is always easy to criticise what was done. But it is also true that monetary policy is all about forecasting inflation and forecasting growth, and using these values to set the short-term rate. And macroeconomic forecasters will always be judged by their average forecast performance. For RBI to become a well respected central bank, it needs to embark on the process of building reputational capital by coming out right on these calls.

Even today, with a short-term rate of roughly 3.5% (after the decline in the repo and the reverse repo rate), the real rate is high. Reasonable values for forecasted inflation now range from -5% to 0%. This suggests that the policy rate is still between 3.5% and 8.5% in real terms. These values are still far bigger than the value of zero which RBI had in place in August 2008. This does not make sense.

And what does this signify?

And yet, the economic significance of these problems is limited. The reason lies in the feeble monetary policy transmission in India. The empirical evidence shows that changes in monetary policy do very little to shake the economy. Monetary policy in India seems to be `a tale told by RBI, full of sound and fury, signifying nothing'.

The Indian intelligensia gets a lot of exposure to the treatment in the international media of central banks such as the US Fed or the Bank of England. There is an aspiration that monetary policy must play a similar role in stabilising the country across the cycle of boom and bust that characterises all market economies. This aspiration reflects the enormous changes which have taken place in India in the last 15 years, and is entirely appropriate. But India is in a primitive institutional environment where monetary policy often does the wrong things, and in any case is feeble.

Making progress requires two things:

Monetary policy must do the right things. In good times, the real rate should go up and in bad times it must go down. RBI has played this precisely wrong in recent years; in good times, the real rate was 0 or negative, and in bad times the real rate has risen. A proper monetary policy process at RBI is required to get this right.

And monetary policy must signify something. It must reach out and influence asset prices all across the economy, through a well functioning monetary policy transmission. While RBI has cut the short rate, this has not influenced much in the economy. At a time when firms have been hit by adverse shocks and require external financing, non-food credit of the banking system has been stalled at Rs.25 trillion or so from September 2008 onwards. Interest rates for corporate bonds have risen sharply in real terms. Since bank lending against equities is walled off, the monetary policy transmission to the stock market is weak.

To achieve a strong and effective RBI that matters, far-reaching changes in Indian finance are required. A well functioning Bond-Currency-Derivatives Nexus, and banking reforms, are required. The path to this has been mapped out in the four reports by R. H. Patil, Percy S. Mistry, Raghuram Rajan and Jahangir Aziz. Every month that goes by without making progress on these reports is one more month of tottering along with malfunctioning fiscal, financial and monetary institutions.